The common litany of complaints about independent venture capital (VC) firms is that many are increasingly trying to invest in older and larger companies in order to reduce the chances the investment will be lost and also for the handful of successful groups to put their larger funds to work more easily. But such trends have left individuals, so-called angels, and specialist, often-government-backed funds to try to seed ideas and support early-stage businesses.
However, alongside the handful of successful incubators, such as oil major Shell’s GameChanger programme (Profile, page 36), have emerged a class of VCs with a business model of developing ideas and partnering their portfolio with the sector’s dominant companies earlier in their life rather than looking to supplant them.
This model is finding renewed favour with investors. US-based life sciences VC Third Rock Ventures closed its second fund at $426m last month. The fund size was an increase from the firm’s debut $378m vehicle raised in 2007, making it one of a handful of groups able to increase its fund size and still be oversubscribed in the two years since the credit crunch constrained investor appetite.
Kevin Starr, co-founder of Third Rock, said its advantage over others was in having "the right model, at the right time with the right team".
He added: "The venture capital model in life sciences is broken, or needs changing, as it is effectively a mutual fund structure of investing in products and ideas.
"We [Third Rock] are going back to venture capital as seeking high levels of cash-on-cash returns by looking for unique company discovery and having a team able to spend two years on an idea and gaining feedback from big business."
Third Rock’s team spends half its time looking for ideas and half building a company, rather than, Starr added, "looking for a founder, checking the science and then providing a cheque and saying ‘see you next quarter’ ".
Third Rock launches and leads many of its portfolio companies as its team of 30 has the capability to act as heads of technology and commercial departments and as chief executive and can spend 8,000 to 10,000 man-hours doing so before bringing in external candidates to take the company on.
Starr said the primary difference between it and traditional VCs was Third Rock’s view of itself as a company builder rather than investor, and so its staff had a mix of scientific, medical, business and strategy backgrounds.
This view stemmed from its founders’ own success as managers. Starr was previously chief operating officer of Millennium Pharmaceuticals, which grew from an $8.5m investment to $8.8bn exit, while another Third Rock co-founder, Mark Levin, had been its chief executive at launch.
To make a success of its incubation model, which includes portfolio companies Alnara (sold to Eli Lilly for at least $180m), Zafgen, Agios and Constellation Pharmaceuticals, Starr said Third Rock had built a portfolio and time-management model similar to that used by pharmaceutical companies for their drug discovery pipeline.
This meant dividing opportunities into A, B and C and having a handful of projects at each stage, with the final category for big ideas that are two to three years away from being a company.
The middle group of projects are usually one to two years away from launch and Third Rock brings a project team led by a senior partner and already including medical groups to work out when an alliance or deal can be struck. If there is only muted interest the project can be killed.
This approach has also been recommended by smaller venture capital firm InLab, which in a white paper last month recommended that due diligence on potential companies should include potential customers.
If it survives, the Third Rock project moves to category A where staff, seed investment and a full business plan is prepared. Time management means each Third Rock staff has to spend a portion of their time in each category rather than the traditional VC model of having one partner responsible for one deal.
Starr said: "The team is more valuable than the individual. We are smart enough to realise we are not that smart, so having a group brings complementary skills together."
In effect, Third Rock has become an outsourced research and development unit for drugs companies looking for three to five times the capital it commits and with fewer failures.
And for the pharmaceutical companies moving from a vertically-integrated model encompassing drug discovery and distribution to patients, to a horizontal model leaving innovation to outside groups and scaling up a portfolio once it started gaining regulatory approval.